Scrapping of reduced VAT rates provokes wider welfare debate

When Iceland piled heavier taxes on to food this year, the International Monetary Fund applauded "this important reform" and urged it to go further.

But the Icelandic Confederation of Labour said the value added tax (VAT) rise drove up prices and hurt the low paid. Halldor Gronvold, the deputy director of the trade union group, said it would fight further reforms: "This is just one battle," he added. "The war is still going on."

Similar arguments are raging across the industrialised world. In the wake of the financial crisis, cash-strapped governments have tended to turn to VAT in spite of concerns about poorer households and potentially negative effects on consumption. Policy experts see scrapping reduced VAT rates as a particularly efficient way of raising cash - some of which can be used to compensate households with other tax cuts.

Rita de la Feria, professor of tax law at Durham University, says an "opportunity for base-broadening tax reform" is emerging. She says there has been a reduction in the number of rates in many EU countries, where standard rates are broadly converging at around 21 per cent.

The argument in favour of scrapping reduced rates is that it removes distortions and complexity. It cements the appeal of VAT as a relatively growth-friendly tax that does not discourage saving and investment. There is often scope to raise big sums by closing loopholes: on average, industrialised countries collect just 46 per cent as much as they theoretically could obtain from a given tax rate, according to the Paris-based OECD.

Iceland, which pushed up its VAT rate to 25.5 per cent - then the highest in the industrialised world - early in the financial crisis, had a highly inefficient system, only collecting 41 per cent of the VAT it could theoretically collect. It has now used cash collected from raising its reduced rate on essentials by 4 points to 11 per cent to cut its top rate from 25.5 per cent to 24 per cent and abolish various commodity taxes.

Bjarni Benediktsson, Iceland's finance minster, intends to go further. "We will continue reducing the number of tax exemptions. The aim is to increase the system's efficiency and promote greater equality among economic sectors."

But increasing VAT is controversial whether it is done by raising rates or tackling reduced rates. It can hit consumption hard. A year ago, the Japanese VAT rate rise - from 5 per cent to 8 per cent - pushed the economy back into recession.

Furthermore, getting rid of reduced tax rates or exemptions is often seen as unfair because it will result in poorer households paying a larger proportion of their income in tax than richer households. An attempt to apply VAT to children's shoes caused the collapse of the Irish government in 1982. More recently, George Osborne's 2012 Budget unravelled when the UK chancellor pushed up VAT on hot takeaway food such as pasties, and on caravans.

In principle, poorer households can be compensated in other ways. The OECD argued that although reduced VAT rates on food and energy increased the progressive nature of the system, they were "a very poor tool" for targeting support to poor households.

But Ms de la Feria says that the current financial climate would make it "extremely difficult - if not impossible" to provide compensation that would make VAT increases on essential goods politically acceptable.

Even so, that leaves scope for big changes. She advised Portugal on the reforms of its VAT - deemed to be "highly inefficient" - required under its 2011 bailout. It moved cultural events, non-essential food and beverages, takeaway and restaurant services to the standard rate. Consumption contracted significantly but the changes were praised by the EU and IMF.

Getting rid of preferential tax regimes is usually unpopular, even if it does not hit poorer households. In Portugal, the VAT changes sparked protests from restaurants and theatres which used prominent actors to criticise the change as an attack on culture.

But Prof de la Feria said the parlous state of the public finances should encourage politicians to take bold decisions. VAT reform should be branded as a way to help the poor, she says. "Now is the time to sell these reforms."

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